1. With equity markets making new cycle highs and the dollar new lows in the last two weeks, many of the core trends in our 2011 asset market outlook had accelerated lately. But the violent moves in commodity markets and FX are a reminder that even strong fundamental stories are vulnerable to sharp corrections if they run ahead of underlying news. Weaker macro news flow has made us a little more cautious and we downgraded our US growth forecasts on Friday. Against this, a sharp easing in financial conditions, strong earnings and some relaxation about fiscal and inflation risks may provide a cushion. So while we have discussed taking a more negative tactical stance for the first time this year, we still prefer to stick with a more neutral view on the cyclical picture and look for opportunities to re-engage with the main trends.
2. Although April proved to be another month where the market did much better during the macro-intensive period between Philly Fed and payrolls, the macro news itself has been less encouraging. Jobless claims, which have tracked the rally well, have moved higher, even adjusting for likely distortions; global PMIs, and new orders indices in particular, have fallen for a second consecutive month; and momentum in our GLI has eased further, albeit to still-robust levels. Jan Hatzius discussed in yesterday’s US Views that although our basic story for the US growth and rates outlook remains intact, the outlook has become cloudier and our conviction has fallen. On Friday, we downgraded our US GDP forecasts for the rest of 2011 and 2012 from 3.5%-4.0% range to 3.0%-3.5% and raised our core inflation forecasts.
3. The market has not ignored these signs of softer growth. US 10-year real yields have fallen from 1.4% in February to 0.7% now and copper was towards the bottom end of its range, even before the drop in the broader commodity complex. Within the US and European equity markets, cyclicals have not outperformed in the last leg of the rally, so the market has risen without upgrading its growth view, which is still well below the levels seen in February. Our Consumer Growth basket which is back to levels not seen in six months also points to a steady downgrade of the US consumer. We had been positioned for some reacceleration of the growth view (first through a short 5-year position and then through a long industrials/short staples trade in US equities). But without help from the data, this has not proved productive and we took off both trades close to flat.
4. Thursday’s large price moves in commodity and FX markets were also a reminder that markets had moved very rapidly in some places. Despite a bullish structural view, our Commodity Research team has argued over the last month that oil markets were moving well ahead of fundamentals and we downgraded our short-term commodity view to underweight in the latest GOAL publication in mid-April. Last week’s correction vindicates David Greely’s out-of-consensus view that the oil market was temporarily over-extended. As Thomas Stolper described in an FX Views on Friday, the spillover into currency markets (particularly EUR/$, where we have recommended long positions) reflected both some overshooting here, but also the impact of lower oil prices, a repricing of European rates after the ECB press conference and fresh worries about Greek sovereign risk. In both cases, the market has provided a timely reminder that when markets move beyond an already-bullish forecast, the signal can be important.
5. The re-emergence of sovereign worry is an indication of how difficult it has been to remove this source of volatility from the agenda altogether. Concerns of potential Greek restructuring and a downgrade to Greek debt have weighed on European equities, particularly banks, and credit coming into this week. Pressure on Greek sovereign spreads has also spilled over into the other program countries as well as Spain and Italy in the last couple of days. As Francesco Garzarelli noted in a European Views earlier today, our central market view remains that we are moving in the direction of increased segmentation between the program countries and other non-core issuers (Spain, Italy, Belgium). We also think that Greece is in a different category to the other two program countries given the size of its liabilities. But we doubt some of the more radical solutions that have been rumoured again lately will be delivered.
6. While the news flow has made us tactically more cautious, particularly as we head into the “macro-light” part of the month, there are also more positive forces countering the muddier macro news. These make it risky to back a more negative view. Earnings season was strong yet again – one more reason to not to see the reported US Q1 GDP figures as an accurate snapshot of underlying trends. The economic data are not without their bright spots, as Friday’s payrolls report showed. And while our Current Activity Indicator does show growth tracking much lower in April than in March, it is still not clear how long that will persist or whether instead it reflects distorted data or the temporary impacts of the oil spike. Nor do the market’s expectations for growth seem overly demanding. Most of the benchmarking exercises using our Wavefront models suggest that the US equity market is priced for GDP growth of 2.5-3.0% over the next year or two. Even after revisions, our US forecasts are above that level. So turning more negative here would risk acting after the horse has bolted.
7. Even more importantly, financial conditions have eased significantly. With the USD hitting new lows recently, 10-year bond yields well off their peaks and equities near cycle highs, our US FCI is below the post-QE2 levels. Even with the dollar reversal on Thursday and Friday, it has eased 50bp since mid-March. Following the sharp drop in oil prices, our “oil-adjusted” FCI has eased even more sharply, by 60bp in the last month. With the latest Senior Loan Officers survey reporting a bigger easing in credit conditions than we expected, the broad financing picture has turned more supportive. While there is always some circularity involved, this means that the slowing in growth is so far coming with some significant ‘automatic stabilizers’, unlike the April-July period last year.
8. With many cyclical assets under pressure, the resilience of equity indices and the weakening in the dollar until late last week have looked somewhat at odds with traditional correlation patterns when the market worries about growth. One simple possibility is that those markets have been levitating a little given a growth slowdown that other markets – and their own internals – are pointing to. As Noah Weisberger discussed in Friday’s daily, the gap that we have identified between our Wavefront Growth basket and the SPX has grown further. And it is possible that the dollar reversal and commodity moves are a sign that equity indices are more vulnerable to the same kind of correction as growth concerns spread. A more benign explanation is that the combination of falling yields, rising equities and a falling dollar provides additional clues as to what has been driving markets lately.
9. The most obvious shift that would motivate this set of asset moves would be a relaxation of US inflation or tightening risk. The market had clearly begun to worry both about higher-than expected US inflation pressure and concerns about the exit from QE2 have also been prominently discussed. A slightly more benign March inflation print, an uneventful FOMC press conference and somewhat softer growth news may have eased those concerns and cemented the notion once again that the Fed will lag well behind most other central banks in tightening. A sense that the US political debate is shifting towards eventually tighter fiscal policy might also be expected to lower rates and weaken the dollar, though its effect on equity markets is somewhat more ambiguous given that a lower risk premium must be balanced against the risks that fiscal tightening poses to growth. The apparent divergence between cyclical assets and equity indices may thus partly reflect shifts in market’s view of the policy outlook and a view that the Fed is likely to be responsive to any sustained growth slowdown.
10. While the markets are acting as if their conviction in a friendly Fed has increased, the story in EM has been less friendly and we have increased our view of the tightening needed in several places. Tushar Poddar correctly anticipated the 50bp hike in India and upped his forecasts of the overall tightening cycle a few weeks ago. Paulo Leme has also increased the tightening we expect in Brazil. And a surprising easing in Chinese credit and financial conditions in March has seen tougher rhetoric there too. Alongside falling EM PMIs, EM equities have been hit hard and the risk is that our shift towards EM equities a month ago has been too early. But Helen Qiao and Yu Song still expect that growth deceleration and easing inflation in China will see the pace of tightening moderate in the next few months even if the reversal of the March “easing” makes the short-term a bit muddier. With agricultural prices flattening out and the reversal in commodity markets extending, we still think policy relief is likely. And with EM capacity pressures the main risk to their markets, a US slowdown would be more helpful than in the DM world, even if the market is not yet reacting that way.
11. All of this leaves us with our core structural views intact, but with a bit less conviction, particularly in the near term. We still expect equities, including in EM, to move higher, credit to tighten further (see the latest Global Weekly for a great summary here) and the USD to extend its weakening. Alongside increased growth risk, part of the difficulty in the asset market outlook has been that prices moved so much more rapidly towards the scenarios we envisaged. That combination has led to more shifts in some of our strategic recommendations. We took our long commodities Top Trade off the table close to target in mid-April close to target and closed our Top Trade in US commercial bank stocks at good gains given the softer US growth picture two weeks ago. There is some tendency to over-interpret these moves, particularly in the press. A decision no longer to be long is, as any investor knows, not the same as a decision to be short, nor does it necessarily reflect a belief that a given asset can not rise further. Our decisions here simply mean that given the moves in prices and fundamentals since December, the risk-reward that we need to justify Top Trades is no longer clear.